Regulatory Proposal Roils Options Sector

Options exchanges and brokerage and trading leaders gathered at the industry’s annual conference in Las Vegas had heated discussions concerning legislation and regulations, especially a proposal to treat all derivatives the same for tax purposes.

The U.S. Securities Markets Coalition, comprised of all U.S. options exchanges and the Options Clearing Corp., circulated comments on the financial products tax reform proposal draft from U.S. House of Representatives Ways and Means Committee Chairman Dave Camp (R-MI).  The proposal has spurred a strong industry effort to beat back the proposed tax changes on covered calls and protective puts, participants said.

Exchanges have responded to Chairman Camp, the OCC is very active on the Hill, and the top firms trading listed options and doing retail business “are showing it will change peoples’ behavior and it will increase the risks they face,” said Paul Jignati, managing director of market structure at TD Ameritrade.

In the proposal, all derivatives, including exchange-traded options, would be treated as sold at year-end, and gain or loss would be treated as ordinary income or loss rather than capital gain or loss.

While tax reformers believe they are making it easier for long-term investors to buy and hold, market participants note that they will be unable to use options as they do today if the measures are adapted. One unintended consequence could be customers shifting from exchange-traded to off-exchange instruments, which is contrary to the direction regulators want trading to move.

Jignati moderated an exchange-leader panel at the OIC conference.  “We had a 45-minute panel and spent 35 minutes on regulatory and legislative topics and 10 minutes on how we’re going to develop and grow the business,” he said.

Comprehensive tax reform in general, and Chairman Camp’s efforts to get input on whether policies outlined would further the goals of simplicity, efficiency, and fairness were lauded by Joe Corcoran, head of the OCC Washington office. “It’s a good process,” he said.

Industry educators are out in force. Much of the pushback is about how uniform tax treatment for all derivatives could disadvantage listed options in the mark-to-market approach and the associated rules for stock that is part of a so-called mixed straddle.

Treatment of appreciated stock as sold when a taxpayer enters into an option transaction that creates a mixed straddle is an example of an issue that is both technical and practical. Is the relevant value for computing gain/loss its fair market value at that time, or another value such as closing price or weighted average? Determining fair market value for thinly traded contracts was another difficulty cited in the U.S. Securities Markets Coalition’s comments.

The proposal would require capturing and retaining many more data points than current law, such as the values of the stock when options are entered into or expire. Though they would have no relevance except for tax purposes, they would require significant configuration changes to reporting systems of retail options brokerage firms, mutual funds, and other institutions and would raise issues about distributing clients’ proceeds given necessary calculation for tax assessment on the ‘phantom’ gains.

“We spent four years and millions of dollars on our systems for the last tax change,” one options brokerage executive said. “This would virtually wipe out all of that.”

Decreased liquidity is seen as the worst side effect of the proposed rule. “Losing liquidity – the cost you have to pay for liquidity – will be a far worse impact than increased trading costs,” Jignati stated.

Market sources noted that the Committee has shown signs of acknowledging pitfalls of its draft tax changes, implying some flexibility and potential openness to rework the proposal.